August 29, 2011
Students in introductory economics classes learn about the housing wealth effect. The basic story is that consumption depends in part on housing wealth. The size of the effect is usually estimated at between 5 to 7 percent, meaning that for every additional dollar of housing wealth annual consumption will increase by between 5-7 cents.
This effect was very important during the years of the housing bubble. The $8 trillion of housing bubble wealth led to a consumption boom that pushed the savings rate to near zero. With the loss of most of this wealth, it was 100 percent predictable that consumption would fall.
This is why it is surprising that the Washington Post had a front page article complaining about weak consumption and the possibility that pessimistic consumers may throw the country back into a recession. While consumers are undoubtedly pessimistic, consumption is actually somewhat higher than would be expected given the loss of wealth. The savings rate is still hovering just above 5 percent, by contrast its post-war average was over 8 percent until it began to be depressed by the stock and housing bubbles in the 90s and 00s.
Source: Bureau of Economic Analysis.
Savings have fallen first and foremost because most of the $8 trillion in housing bubble wealth that was driving consumption has disappeared since the collapse of the bubble. Consumer sentiment, especially about future conditions, is a very poor predictor of consumption. The most obvious explanation for the weakening of consumption in the second quarter was the surge in oil prices which reduced real incomes. With oil prices falling again in the last two months, most economists expect somewhat of an upturn in consumption in the second half of 2011.
It is also important to note that the article is fundamentally confused about debt and its relation to consumption. Consumer debt is an asset for someone else. To a large extent, the debt of consumers is wealth to other consumers. For example, most mortgage debt sits in mortgage backed securities. These securities are owned by institutional investors (e.g. pension funds, university and foundation endowments) and individuals, either directly or through retirement accounts. The debt only affects consumption insofar as the debtor has a greater propensity to consume out of wealth than the creditor. This explains how consumption can still be unusually high, even though the debt to income levels remain unusually high.
Unless another asset bubble again propels consumption by pusing the savings rate to extraordinarily low levels, the factor that will eventually have to lift the economy is an improving trade balance. This is not a matter of speculation, it is an accounting identity. That means it has to be true.
The Post might give better reporting on these issues if it did not rely exclusively on economists who were unable to see the housing bubble.
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